Defensive value portfolio review – 2016 Q2

Now that the exceptionally volatile second quarter of 2016 is over, it’s time for another quarterly review of my defensive value model portfolio and its performance against the FTSE All-Share.

Recent performance: Brexit leads to surprise gains

When the leave result was announced the model portfolio fell by about 8% while its FTSE All-Share tracker benchmark fell about 6%, but within a couple of days both were trading above where they were before the referendum and above where they were at the start of the June.

To be honest, I was surprised to see the large-cap end of the market recover so quickly, but having looked at some of the post-referendum market moves in more detail I now have at least some understanding of why that was the case (primarily a fall in the pound combined with the international focus of many large-cap stocks).

Long-term performance: Comfortably ahead of the market

Of course price movements over one month should be largely irrelevant to long-term investors. It is the multi-year performance which really matters and on that front, the model portfolio is still a long way ahead of the zero-effort alternative of a FTSE All-Share tracker:

Model portfolio performance 2016 07
Past performance is not a guide to future performance
Model portfolio performance table 2016 07
The model portfolio is having a good run at the moment

The performance goals for the model portfolio are that it should be high yield, high growth and low risk all at the same time. In other words:

  • Higher yield than FTSE All-Share: Preferably more than 110% of the FTSE All-Share’s yield
  • Higher total return than FTSE All-Share: Measured over five years or more and preferably at least 3% per year better
  • Lower drawdowns than the FTSE All-Share: Measured as maximum peak-to-trough decline over five years

So far the portfolio has comfortably exceeded each of these targets and so I’m happy with its performance to date, although of course, I would like it to be even better in future.

Brexit highlights the need for risk control through diversification

I do sometimes get accused of banging on endlessly about diversification, but I make no apologies for it. For the vast majority of investors, passive and active alike, knowing how to diversify your portfolio is incredibly important.

The UK’s decision to leave the EU is a good reminder of how uncertain the future is and therefore how difficult it is to fine-tune a portfolio for one specific future.

I think a much more sensible approach is to build a portfolio which should do reasonably well under a wide range of possible futures, from the exceptionally good to the catastrophic.

I manage the diversity of this model portfolio by controlling:

  • Exposure to any one company: Hold around 30 companies with no more than 6% of the portfolio in any one position
  • Exposure to any one sector: No more than three holdings from the same sector
  • Exposure to any one country: No more than 50% of the portfolio’s aggregate revenues should come from the UK
  • Exposure to cyclical sectors: At least half of the portfolio’s holdings should be in defensive sectors

In practice that produces a portfolio which looks like this:

Model portfolio position sizes 2016 07
Most holdings are between 3% and 4% of the portfolio, with none more than 6%
Model portfolio sector allocation 2016 07
The portfolio is spread across a wide range of sectors (click to enlarge)
Model portfolio revenue source 2016 07
Brexit shows that international diversity is usually a good idea
Model portfolio cyclical-defensive 2016 07
Aiming for a balance between cyclical and defensive sectors
Model portfolio size allocation 2016 07
Attractive investment opportunities exist across the size spectrum

Brexit winners and losers

Unsurprisingly there has been a huge amount of volatility as a result of the EU referendum and within the portfolio, there have been some notable winners and losers.

On the winning side, BP took the prize with gains of more than 25% in a single month. Quite frankly that’s astonishing given what that means in terms of additional market value (about £15bn added in one month).

Following closely behind BP were the portfolio’s other commodity-related holdings which were all up by a substantial amount, with defensive sector stocks such as Tobacco and utilities close behind.

Leading the losers was The Restaurant Group, down more than 20% in a month and more than 60% over the last six months.

Joining TRG as a major loser was the portfolio’s other retailer, which wasn’t a massive surprise as retailers have been hit very hard due to increased fears of a UK recession.

This sort of double-digit volatility can scare the living daylights out of even the most calm and sensible investor and perhaps lead them into making quick and often unwise decisions (typically to sell and head for the “safety” of cash).

My approach to combating stress at times of heightened volatility and uncertainty is threefold:

  1. Don’t look at the market: Don’t check up on the value of the FTSE 100 or your portfolio and don’t read market-related news. Go and do something else instead.
  2. Don’t look at your individual holdings: If you absolutely must look at your portfolio then concentrate on your portfolio’s overall value rather than the ups and downs of your individual holdings. It will be less volatile and therefore less scary.
  3. Don’t make rash decisions: If for some reason you feel compelled to make a trade, sleep on it first. Hopefully tomorrow you’ll be able to make a sensible decision with a clear head.

Recent buy and sell decisions

Investing isn’t all about sitting around ignoring the market though; sometimes you do have to actually do something and in the last quarter I made three trades, one per month, which has been my trading policy for many a year.

In May: I sold Tesco, which wasn’t exactly a stellar success. The investment lost about 38% over almost three years, but at least there were many important lessons learned which I’ll apply to all future company analyses.

In June: I reinvested the proceeds from Tesco into a new holding, a FTSE 250-listed Aerospace & Defence company. That brings the total number of holdings in that sector to three.

In July: I sold Reckitt Benckiser, which for the second time has turned out to be an exceptional investment. Total returns came to 63% over about two and a half years which is far more than I would normally expect.

So one more quarter bites the dust and a sensible and steady approach to active investing is still producing better results than the theoretically unbeatable market index.

Over the next quarter and beyond we are going to be in even more uncertain times and for me that makes sticking to my investment plan all the more important.

And finally, if there are any other aspects of portfolio management you’d like me to cover in these quarterly reviews, just let me know in the comments.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

6 thoughts on “Defensive value portfolio review – 2016 Q2”

  1. Hi John,

    Reading your blog on the performance over the past 5 years, my only comment is that I have read that to have 30 holdings you in fact have a closet tracker fund, but you have beaten the FTSE All Share handsomely, so you must be doing something right ! Keep up the good work !

    1. Hi Geoffrey,

      There’s something called ‘active share’ which measures how different a portfolio is to a benchmark. I calculated it for the model portfolio a couple of years ago but haven’t since. From memory I think the value was quite high, although the exact number escapes me.

      I think if I had 30 holdings from the FTSE 100 it might be harder to differ from the index, but the portfolio is spread across the All-Share index which has about 650 companies in it. So with just 30 out of a possible 650 stocks I think there’s a lot of room for difference!

  2. Do you calculate a sharp ratio and compare it to the market? Do you check your holdings are decorrelated as required by modern portfolio theory? Are you on the efficient frontier? Just chucking a few ideas at you in the spirit of constructive criticism.

    1. Hi Andrew: No, no and no! As long as I have higher yield, higher total return and lower risk then I’m happy.

      I do calculate 3-yr Beta, which is currently 0.4 for the model portfolio relative to the FTSE All-Share tracker. Anything below 1 means lower risk.

      Having just punched the numbers into a spreadsheet, the Sharpe ratios (a measure of risk-adjusted return for those who don’t know), using a risk-free rate of 3.5%/yr (as they do on are:

      0.22 for the model portfolio (based on 0.58% excess monthly return and 2.63% standard deviation of those excess returns)

      0.07 for the FTSE All-Share tracker (based on 0.23% excess monthly return and 3.15% standard deviation of excess returns).

      Higher is ‘better’, so the model portfolio’s Sharpe ratio is ‘better’, although I’m not a financial statistician and my interpretation may be wrong.

      The M2 ratios (which converts the Sharpe ratio into a risk-adjusted percentage return for easier interpretation) are:

      1% monthly return for the model portfolio and 0.5% for the All-Share. In other words, if the model portfolio was as risky as the All-Share (remember, it’s actually less risky) then it would have returned 1% per month compared to an actual return from the All-Share of 0.5% per month.

      That’s would be a return of about 12% per year compared to a 6% return per year from the index, if they were equally risky.

      So I’m quite happy with twice the rate of risk-adjusted returns, although of course that’s in the past and the future remains as uncertain as ever.

      Thanks for bringing this to my attention though; I may well add the M2 ratio into my next quarterly review.

  3. John,

    Read your article (pdf) re valuations on the defensive and in particular drinks industry.
    I’m a Diageo investor and recently sold SabMiller.
    I’ve always looked upon AG-Barr and Britvic with fondness, but never invested.
    Why, well simplistically I suppose, and in reference to AG Barr I don’t like their core products – Irn-Bru — have you ever tasted it? — It’s dreadful stuff.

    OK that’s a case of letting your emotions pass up on a good investment return !!

    For Britvic – this is the opposite, I love Robinsons and the mixer products etc, but the debt — I like this a little less and stops me piling in.


    1. Hi LR, yes I think Britvic’s debts are a little worrying and would stop me investing too.

      As for Irn-Bru it’s an acquired taste but is #1 in Scotland so I’m assuming at least some of them buy it for the flavour!

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